Cost Concepts

A firm's short-run cost structure is built from a small set of interlinked cost concepts, all of which a BIEAP Intermediate first-year Economics student is expected to define, distinguish, and compute from a numerical schedule.

Total costs

• Total Fixed Cost (TFC) — cost of the fixed factors (rent, insurance, interest on borrowed capital, depreciation of plant); it does not change with the level of output, and must be paid even at zero output.
• Total Variable Cost (TVC) — cost of the variable factors (raw material, wages of casual labour, fuel); it rises as output rises, from zero at zero output.
• Total Cost (TC) — the sum of the two: $TC = TFC + TVC$.

Per-unit (average) costs

• Average Fixed Cost: $AFC = \dfrac{TFC}{Q}$ — always falls continuously as output rises, since a constant TFC is spread over more units (spreading the overheads).
• Average Variable Cost: $AVC = \dfrac{TVC}{Q}$ — typically U-shaped: falls initially (increasing returns to the variable factor), then rises (diminishing returns).
• Average Cost (or Average Total Cost): $AC = \dfrac{TC}{Q} = AFC + AVC$ — also U-shaped, for the combined reason that AFC keeps falling while AVC eventually rises.

Marginal cost

Marginal Cost (MC) is the addition to total cost from producing one more unit of output:

Since TFC does not change with output, MC is also equal to the change in TVC alone. MC is U-shaped, falls first (reflecting increasing marginal returns to the variable factor) and then rises (reflecting the Law of Variable Proportions setting in) — cost curves are, in effect, the Law of Variable Proportions viewed from the cost side rather than the output side.

The MC–AC relationship …